Personal Finance: Thoughts on peer to peer lending

A year back I decided to try peer to peer(P2P) lending (out of curiosity) will a small sum of money.
My net conclusion is that peer to peer lending is not a sensible form of investing.
My money is still stuck (and that’s not the only reason why I would recommend people to stay away from it).

How it works

A lender with say 1000$ will go to a site like lendingclub.com or prosper.com and will loan money directly to people in units of say, 25$ notes. The loan (with interest) will be paid back in fixed period of time (36 or 60 months).

Reasons why I dislike P2P lending

Income counted as regular incomeThe income counts as ordinary income and is treated at marginal income tax rates which is usually much higher rate then long terms capital gains and dividends. Not to ignore that if a person is living in high tax state like California, the state tax applies as well. So, the after tax rate of P2P lending is approx. 20% lower than equities.
Note: This does not apply if you are using Roth IRA account for investment.

Tax inefficientThe lender will get a fixed amount of money every month (except for defaulted loans) unlike capital gains, there is no way to keep it unrealized and timing it (Eg. postponing gains for a year). Even worse sometimes the creditors will pay back well in advance.
Note: This does not apply if you are using Roth IRA account for investment.

Too much of workUnless the lender is ready to put in a minimum sum (~25, 000 $), the task cannot be automated.
In my opinion, investing one’s savings in chunks of 25$ units is not the best investment of one’s time.
Also, from time to time some creditors will pay back earlier forcing lender to spend time reinvesting that money.

No liquidityWhile equities and bonds can be sold at will (Eg. in case of a better opportunity or emergency), that’s not the case with P2P lending. The notes can be sold though (through trading platform provided by P2P sites), but only at a loss.

Money is not always investedWhile one can buy equities/bonds anytime in open market, P2P lending will not begin till the funding is finished. Eg. As a lender, you saw someone requesting a loan of 10, 000$ and decided to buy notes worth 1000$, but the rest of 9000$ did not arrive for next one week then the investing period won’t begin till then (even worse, all the loan requests have deadline and if requests is not 100% fulfilled then the loan will not be granted and you will get the money back after one week of lock-in and no gains). Therefore, the net annualized returns are misleading.

The bottom line is simple: If you want to try out P2P lending for fun then go ahead and try with small amount of money. Serious investors should probably stay away from it.

[…] What about P2P lending? Income from P2P lending is considered regular income and losses are not tax-deductible, therefore, from a financial perspective, it makes sense to invest only via Roth IRA. Apart from that, I believe its too much hassle in terms of time (see my previous post on Peer to Peer lending). […]